Download The Case for a Concentrated Portfolio

The Case for a
Concentrated Portfolio
A CONCENTRATED PORTFOLIO IS A HIGH-CONVICTION STRATEGY that can serve as an effective component of a well-executed asset
allocation strategy. We have found that a focused group of well-researched companies, each with a sustainable long-term competitive
advantage, can provide superior protection against a permanent loss of capital when compared to portfolios with a higher number
of holdings each with a lower degree of conviction. Further, with fewer companies to oversee, concentrated portfolios allow portfolio
managers to more intimately understand their companies, and own their best ideas, thereby decreasing the risk of underperformance.
Know Your Companies
A concentrated portfolio focuses on fewer companies, allowing
a portfolio manager to devote more time and resources toward
obtaining a more complete picture of the companies’ longterm competitive advantages. If a manager has fewer stocks to
look after, he or she can develop a deep understanding of the
business and how appropriate its current valuation is. This depth
of knowledge facilitates making educated decisions on whether
to hold, increase, or sell a position, which can improve both
downside protection and upside potential.
Conversely, having too many different positions prohibits
managers from understanding the businesses as intimately as
needed. This is problematic because the risk involved in buying
a security is chiefly determined by how well one understands
it. For example, it is clearly less risky to own 35 stocks that you
know extremely well (and have purchased at an attractive
valuation) than it is to own 50 or more stocks that you have spent
little time investigating.
John Maynard Keynes was one of the earliest economists to
express this idea.
Other notable investors have echoed this sentiment in recent
years, including Warren Buffett, who has frequently extolled the
benefits of picking fewer sensibly-priced companies with longterm competitive advantages instead of pursuing conventional
diversification.
[If] you are a know-something investor, able to
understand business economics and to find five to ten
sensibly-priced companies that possess important longterm competitive advantages, conventional diversification
makes no sense for you. It is apt simply to hurt your
results and increase your risk.2
In lieu of a portfolio manager putting money into a business
that is his 51st favorite idea, it makes more sense—as Mr. Buffet
explained—to simply increase his investment in “his top choices–
the businesses he understands best and that present the least
risk, along with the greatest profit potential.” Adding new
securities should be justified based on the manager’s conviction
and not merely by the need to diversify.
I get more and more convinced that the right method
of investment is to put fairly large sums into enterprises
which one thinks one knows something about and in the
management of which one thoroughly believes. It is a
mistake to think one limits one’s risk by spreading too
much between enterprises about which one knows little
and has no reason for special confidence.1
Kayne Anderson Rudnick Investment Management 1
Enhance Returns
Adding more stocks to a portfolio solely for the sake of
diversification tends to water down returns. As the portfolio
looks more and more like the benchmark, the likelihood of
outperformance decreases. Further, a large number of different
securities in a portfolio typically means the equity positions are
so small (sometimes only 0.2% to 1%) that no individual stock can
affect portfolio returns—negatively or positively—with any real
degree of significance. The result is often just a high number of
average companies generating only an average return on capital.
Accordingly, this process is sometimes referred to as “overdiversification” or “closeted indexing,” because these “active”
portfolios begin to look more and more like their benchmarks.
FIGURE 1: RETURNS
Russell 3000® Index
16%
14%
12%
10%
8%
6%
4%
2%
0%
This behavior is counter-productive because managers’ best
ideas have a stronger likelihood of outperforming over time.
Researchers from MIT and the London School of Economics
analyzed monthly stock returns and quarterly fund holdings data
of U.S. equity funds over the period 1984 to 2007, and found in
their aptly titled paper Best Ideas, that equity managers’ highest
conviction ideas outperformed the market as well as the other
stocks held in the managers’ portfolios, by 1.0% to 2.5% per
quarter.3
The focus on fewer and higher conviction investments increases
the chance that a strong performer will have an outsized positive
impact on the account. This is a finding reinforced by professors
Baks, Busse, and Green from Emory University’s Goizueta School
of Business. In their paper entitled Fund Managers Who Take Big
Bets: Skilled or Overconfident, the authors recognized the value
of portfolio concentration.
Our evidence indicates a positive relation between fund
performance and managers’ willingness to take big
bets in a relatively small number of stocks. Concentrated
managers outperform their more broadly diversified
counterparts by approximately 30 basis points each
month, or roughly 4% annualized.4
In comparing concentrated portfolios to non-concentrated
portfolios, we looked at data through June 2016 from the
following eVestment universes: Non-U.S. Diversified Equity, U.S.
Large Cap, U.S. Mid Cap, U.S. Small-Mid Cap, U.S. Small Cap,
U.S. All Cap, and U.S. Micro Cap. Figure 1 shows our findings;
concentrated portfolios (here with 35 or fewer holdings)
outperformed larger, non-concentrated portfolios (50 or more
holdings) in the prior 5, 7, and 10-year windows.
Of particular interest is that during these time periods, these
2 Kayne Anderson Rudnick Investment Management
5 Years
7 Years
Concentrated (<=35 Stocks)
10 Years
Non-Concentrated (>=50 Stocks)
FIGURE 2: UP-MARKET CAPTURE
Russell 3000® Index
100%
95%
90%
85%
80%
75%
5 Years
Concentrated (<=35 Stocks)
7 Years
10 Years
Non-Concentrated (>=50 Stocks)
Data presented is for the period ending June 30, 2016.
Figure 1: Universe average annualized returns. Figure 2: Universe average up-capture for
annualized periods. Data is obtained from FactSet Research Systems and is assumed to be
reliable. Past performance is no guarantee of future results.
concentrated portfolios captured almost as much, if not more, of
the up-market returns as the non-concentrated portfolios did, as
shown in Figure 2.
However, they captured less of the down market performance, as
shown in Figure 3.
In other words, concentrated portfolios can do as well as larger,
non-concentrated portfolios when the market is healthy, and they
tend to hold up better during difficult market environments.
Decrease Risk
FIGURE 3: DOWN MARKET CAPTURE
Russell 3000® Index
140%
A common fallacy about concentrated portfolios is that they
are inherently more risky. This misconception exists because
the relationship between diversification and volatility has been
over-stated for years, leading many investors to believe they can
only properly diversify away risk by including a large number of
stocks. Yet, as Warren Buffet once said, “wide diversification is
only required when investors do not know what they are doing.”5
120%
100%
80%
60%
In fact, Figure 4 uses the same set of data to demonstrate how
concentrated portfolios actually experienced lower levels of
standard deviation (risk) than non-concentrated portfolios did in
the prior 5, 7, and 10-year windows.
40%
20%
0%
5 Years
7 Years
Concentrated (<=35 Stocks)
10 Years
A minimum level of diversification is needed to reduce portfolio
risk, but after a point, adding more stocks to the portfolio does
not significantly reduce risk, and may in fact diminish returns.
Numerous studies have shown that a relatively small number of
stocks can provide most of the diversification that an investor
actually needs. In fact, the diversification benefit of adding
additional stocks to a one-stock portfolio is largely captured
within the first few additions, as illustrated in Figure 5.
Non-Concentrated (>=50 Stocks)
FIGURE 4: STANDARD DEVIATION
Russell 3000® Index
18
16
14
Furthermore, even a portfolio of well-diversified assets cannot
escape all risk. It will still be exposed to systematic risk, which
is the uncertainty that faces the market as a whole. Also known
as “undiversifiable risk,” “volatility,” or “market risk,” systematic
risk cannot be diversified away. However, it can be mitigated
by diversifying beyond equities into asset classes such as cash,
fixed income, and alternative investments. For this reason, a
partial allocation to a concentrated equity strategy can also
make sense as part of an overall asset allocation plan. This
approach is preferable to investing in “closet indexers” or fund
managers whose mandate prohibits them from investing heavily
in their best ideas because research has shown that the extra
attention these fewer holdings demand may deliver strong, even
superior, returns in the long run.
12
10
8
6
4
2
0
5 Years
7 Years
Concentrated (<=35 Stocks)
10 Years
Non-Concentrated (>=50 Stocks)
FIGURE 5: DIMINISHING IMPACT OF
ADDITIONAL HOLDINGS
50%
Portfolio Standard Deviation
45%
40%
35%
30%
25%
20%
15%
10%
5%
0%
0
10
20
30
Number of Stocks in Portfolio
40
50
Data presented is for the period ending June 30, 2016.
Figure 3: Universe average down-capture for annualized periods. Figure 4: Universe average
annualized standard deviation. Figure 5: Assumes inter-stock correlation of 0.1 and average
stock standard deviation of 45%. For illustrative purposes only. Data is obtained from FactSet
Research Systems and GEAM (based on Modern Portfolio Theory) and is assumed to be
reliable. Past performance is no guarantee of future results.
Kayne Anderson Rudnick Investment Management 3
Reduce Correlation
Concentrating an equity portfolio in fewer stocks can also
help reduce a portfolio’s correlation to overall market returns.
High-conviction ideas, those without a “top-down” bias (or
predisposition to thematic or macro-economic drivers), tend to
have a low correlation to each other, and therefore help mitigate
non-systematic risk within a portfolio. As demonstrated in Figure
6, concentrated portfolios are characterized by a lower stockmarket correlation than non-concentrated portfolios.
FIGURE 6: CORRELATION TO RUSSELL 3000® INDEX
0.94
0.92
0.90
0.88
0.86
0.84
0.82
Further, over the same timeframes, concentrated portfolios
have demonstrated lower correlation than non-concentrated
portfolios when compared to other major asset classes including
international developed equities, emerging markets equities,
and U.S. corporate debt, as shown in Figure 7.
0.80
0.78
0.76
5 Years
7 Years
Concentrated (<=35 Stocks)
Conclusion
A concentrated portfolio in and of itself is not necessarily a wise
investment strategy. Such an approach can only generate alpha
(risk-adjusted excess returns) if it is accompanied by a strong
research process capable of uncovering quality companies
at attractive valuations. However, limiting a portfolio to a
smaller pool of businesses does improve a manager’s depth
of knowledge of each company and focuses his or her clients’
capital in the manager’s very best ideas. By focusing on those
companies in which a manager has the highest conviction,
one is likely to capture strong returns, and often with less risk.
A concentrated portfolio can thereby serve as an effective
component of a well-executed asset allocation strategy.
1.00
10 Years
Non-Concentrated (>=50 Stocks)
FIGURE 7: CORRELATION TO INTERNATIONAL
DEVELOPED EQUITIES, EMERGING MARKETS
EQUITIES, AND U.S. CORPORATE DEBT
0.80
0.60
0.40
0.20
0.00
-0.20
MSCI® MSCI® Barclays
EAFE Emerging U.S.
Index Markets Credit
Index
Bond
Index
MSCI® MSCI® Barclays
EAFE Emerging U.S.
Index Markets Credit
Index
Bond
Index
MSCI® MSCI® Barclays
EAFE Emerging U.S.
Index Markets Credit
Index
Bond
Index
5 Years
7 Years
10 Years
Concentrated (<=35 Stocks)
Non-Concentrated (>=50 Stocks)
Data presented is for the period ending June 30, 2016.
Universe average correlation. Data is obtained from FactSet Research Systems and is assumed
to be reliable. Past performance is no guarantee of future results.
Kayne Anderson Rudnick
Kayne Anderson Rudnick is a boutique investment firm specializing in high-quality investment strategies. The firm has a 30-year
history serving a diverse client base that includes corporations, endowments, foundations, public entities, taft-hartley clients, and
mutual funds. With $12 billion in assets under management, Kayne Anderson Rudnick is known for its commitment to high-quality
investment strategies and business practices. For more information, please visit www.kayne.com.
This report is based on the assumptions and analysis made and believed to be reasonable by Advisor. However, no assurance can be given that Advisor’s opinions or expectations will be correct.
This report is intended for informational purposes only and should not be considered a recommendation or solicitation to purchase securities. Past performance is no guarantee of future results.
1. Keynes, John Maynard. Letter to business associate, F. C. Scott, on August 15, 1934. www.maynardkeynes.org, 2015
2. Buffet, Warren. Chairman’s Letter – 1993. Berkshire Hathaway Inc., 1994
3. “High Conviction Equity: Why Fewer Names May Be Better,” GE Asset Management, October 2012
4. Baks, Klaas P., Busse, Jeffrey A. and Green, T. Clifton. “Fund Managers Who Take Big Bets; Skilled or Overconfident,” Emory University Goizueta Business School, March 2006
5. Orfalea et al. “Buffet Teaches Us to Concentrate,” Exclusive outlook, West Coast Asset Management, The Entrepreneurial Investor, July 2007
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